Chart 1

S&P Global Ratings Research expects the U.S. trailing-12-month speculative-grade corporate default rate to increase to 3.9% by September 2020 compared with 2.8% as of September 2019 (see Chart 1).  The Fed has stepped it up again in October, providing a third interest rate cut in only three months. This move should help keep corporate borrowing costs stable, but the positive effects could be limited. This is because the economy is expected to slow next year, which might be enough to affect the growing percentage of the weakest borrowers (as opposed to needing an outright recession as a trigger). Speculative-grade borrowing costs have been more volatile over the past nine months, particularly for issuers in the 'B' and 'CCC'/'C' categories. Economic and financial indicators continue to signal that borrowing costs could rise further in the months ahead or that they are lower than what the macroeconomic backdrop would seem to indicate.

In our pessimistic scenario, we forecast that the default rate will rise to 5.2%.  This forecast assumes the U.S.-China trade dispute will backslide into a more hostile tone, resulting in the U.S. enforcing additional tariffs. These would likely be met with countermeasures by the Chinese, resulting in increased financial market volatility, decreased trade, and a hit to the real economy, particularly if many consumer products were affected. Moreover, impeachment proceedings could cloud the U.S. political landscape, which has an already high chance of negatively affecting financial market sentiment if the general election outcome becomes uncertain as the election nears.

In our optimistic scenario, we forecast the default rate will fall to 2.5%.  We assume an improved trade situation between the U.S. and China in this scenario, with U.S. tariffs on Chinese imports falling back to 10% or lower. We would also assume in this scenario that the Fed could cut interest rates again as extra insurance against a recession, forcing investors to return to bonds and loans in the lower rating categories in their hunt for yield. An improvement in the trade dispute--with balanced results--should help extend consumers' current high spirits.

Despite Strong Consumer Sentiment And Stable Oil Prices, The Consumer And Energy Sectors Are Likely To Lead Near-Term Defaults

In recent years, defaults have been muted across most sectors. The exceptions were energy and natural resources, which had default spikes in 2016, largely because of dramatically falling oil prices. More recently, however, defaults have become more frequent in the consumer services sector, which includes consumer products and retail/restaurants. These sectors have faced fundamental difficulties in recent years as consumers shift more of their purchases online and increased price discovery squeezes margins.

Together, the energy and consumer services sectors account for 43.2% of all U.S. firms currently rated 'CCC+' or lower by S&P Global Ratings.  Retail sales have been growing steadily, reaching a 4.1% year-over-year growth rate through September, and consumer confidence remains high heading into the holiday shopping season. Meanwhile, oil prices have had some volatility recently, rising to $63.1 per barrel on Sept. 16 after the attacks on Saudi Arabian facilities. That country quickly moved to resume production and allay fears among global oil markets. Since then, the price of West Texas Intermediate has returned to the relatively tight range of $50-$60 per barrel that has prevailed since May. Although falling, the current price is in line with S&P Global Ratings' price assumptions (see "S&P Global Ratings Lowered Its Henry Hub Natural Gas Price Assumption For The Rest of 2019 And For 2020, 2021; Long-Term U.S. Natural Gas, Canadian AECO, And Crude Oil Price Assumptions Unchanged," July 29, 2019).

These two sectors have accounted for the majority of defaults in recent years (see Chart 2).  In fact, excluding the energy and natural resources and consumer services sectors, the default rate was only 1.52% for the 12 months ended Sept. 30.

Chart 2

Most sectors within the speculative-grade segment are likely to have increased downgrades over the next 12 months, and typically heightened downgrades precede defaults.  Chart 3 comparess net rating actions (upgrades minus downgrades, as a proportion of the issuer base) over the prior 12 months with the net rating bias (current positive bias, or the proportion of issuers with positive outlooks or ratings on CreditWatch with positive implications, minus current negative bias) by sector. Only three of 13 sectors are showing reduced downgrade potential relative to their recent experience. Some of these more stressed sectors are relatively small contributors to the overall speculative-grade population (forest products building materials/homebuilders as well as transportation), but the consumer services sector is both the largest (16%) and has the highest current net negative bias at negative 27.5%.

Chart 3

Funding Dynamics Have Shifted, But Issuance Is Lower

Speculative-grade firms have been changing their funding mix since the Fed started moving in a more accommodative direction this year.  Generally, in anticipation of falling interest rates, leveraged loan volumes are far off from their 2018 year-to-date totals, while speculative-grade bonds are far outpacing last year's haul. Through October, speculative-grade bond issuance has reached $181.6 billion, up from $137.5 billion at the same point last year. This puts speculative-grade bond issuance in 2019 up roughly 32% over 2018 levels. We expect the strong, double-digit growth rate to continue through the remainder of the year, even if bond issuance slows to more typical historical trends.

Meanwhile, leveraged loan issuance totaled $435.5 billion through October compared with $573.1 billion over the same period, a decline of 24%. In all, combined leveraged loan and speculative-grade bond issuance is down 13% from last year despite the heady growth among bonds (see Chart 4). Still, these issuance totals are well above the roughly $137.4 billion in outstanding debt set to mature next year.

Chart 4

Default Signposts Show Mixed Signals

Financial conditions are generally stable but showing some weakness.  Industrial production has been slowing, while the proportion of lowest-rated issuers has been growing (see table). Corporate after-tax profits continue to show small gains--or even losses--this year, credit quality within speculative-grade continues to deteriorate, and the negative bias indicates more deterioration to come.

We anticipate profits will be roughly flat to slightly negative in the third quarter.  After-tax corporate profits rose 1.3% on a year-over-year basis in the second quarter, in an expected cessation to the large gains seen in 2018, which was the first year under the new tax code. Thus far, about 90% of the S&P 500 constituents have reported third-quarter earnings, which in total are showing about a 1% decrease from last year. That said, many sectors more heavily represented in the speculative-grade segment (energy, materials) have thus far reported significant declines of over 20%.

Lending conditions appear broadly neutral, but concerns are rising.  The Fed's fourth-quarter 2019 Senior Loan Officer Opinion Survey showed that on net, lending standards on commercial and industrial loans for large and medium-size firms tightened in the third quarter, by 5.4%. This tightening was largely driven by a less-favorable, more-uncertain outlook, reduced risk tolerance, a deterioration of industry-specific problems, and decreased liquidity in secondary markets.

The consumer remains strong.  At 3.6% in October, the unemployment rate is still near an all-time low. Inflation remains below 2%, and GDP growth came in at 2% in the third quarter, annualized. This has helped keep consumer sentiment (as measured by the Conference Board) elevated, if not at its all-time high a year ago. These factors are creating a rare combination of a growing economy with low interest and inflation rates.

A Manageable Maturity Total could Mask Sector-Specific Stresses

In 2020, approximately $137 billion in outstanding speculative-grade debt is scheduled to mature, with $37 billion of that total rated 'B-' or lower. This is a historically low amount and well below the $617.1 billion in total bond and leveraged loan issuance over the 12 months ended October, indicating the larger speculative-grade population's issuance totals are well above upcoming principal payments in 2020.

That said, there are some sectors that are displaying potential funding risk. These include homebuilders/real estate, oil and gas, and telecommunications, which have all had either substantially reduced speculative-grade bond issuance thus far in 2019 or which have upcoming bond maturities well above their recent issuance trends (see Chart 5). Despite stabilizing oil prices, the oil and gas sector appears to have faced a difficult funding environment recently. Through September, the speculative-grade oil and gas sector had only $6.6 billion in bond issuance in 2019. This is well off previous years' totals of $23.1 billion in 2018, $31.6 billion in 2017, and over $20 billion in the two prior years. If this drop-off continues, the sector could face heightened stress in paying off upcoming principal payments, which we estimate total about $12 billion in 2020 and $21 billion in 2021.

Chart 5

Financial Markets Show Some Caution But Remain Optimistic

The relative risk of holding corporate bonds can be a major contributor to future defaults because firms face pressure if they are unable to refinance maturing debt. One measure of this relative risk is the U.S. speculative-grade corporate spread, which reflects near-term market expectations for overall stress in the speculative-grade market. In broad terms, the speculative-grade spread is a good indicator of future defaults based on a roughly one-year lead time (see chart 6). That said, at current spread levels, our baseline default rate forecast of 3.9% is above what the historical trend would suggest.

Chart 6

Within the speculative-grade segment, there has been a recent divergence in financing conditions between 'BB' rated issuers, and those with lower ratings, which might be reflecting some amount of investor caution over the last two years. After falling to a relatively low level after the spike in defaults among the oil and gas sector, the 'B' over 'BB' spread has been rising since the fourth quarter of 2018 (see chart 8). This has coincided with a slight decline in 'B' issuance, while the pace of 'BB' issuance has grown. Given expectations for slower economic growth in the U.S., alongside periodic market stress from the ongoing U.S./China trade dispute, this could imply investors are shifting funds away from riskier borrowers, which could spell higher defaults, all things being equal.

Chart 7

That said, it is possible investors are still slightly more optimistic than the underlying economy and financial markets suggest. Using a model based on the three broad measures of the VIX, the M1 money supply, and the Purchasing Managers' Index, we estimate that at the end of October, the speculative-grade bond spread in the U.S. was about 74 basis points (bps) below where our model would suggest (see chart 9).

This gap could indicate that spreads are below where the larger economy and financial markets would suggest.  Through most of the postrecession period, the spread was slightly higher than predicted. But the predicted level has exceeded the actual for 17 of the past 22 months--a phenomenon not seen since late 2007 through early 2008, right before spreads shot up past 1,000 bps, leading to a spike in the default rate roughly a year later. During that time, the gap persisted for an extended period of three and a half years prior to a surge in spreads, and the magnitude of the gap was also larger than it is now. However, the current gap has been increasing in both magnitude and duration.

Chart 8

While the speculative-grade spread is a good indicator of broad market stress in the speculative-grade segment, defaults are generally rare during most points in the economic cycle outside of downturns. However, even in more placid conditions, there has never been a 12-month period with no defaults in the U.S. With this in mind, we feel a more targeted indicator of future defaults across all points in the credit and economic cycles is the corporate distress ratio (see Chart 9).

Chart 9

The distress ratio (defined as the number of distressed credits, or speculative-grade issues with option-adjusted composite spreads of more than 1,000 bps relative to U.S. Treasuries, divided by the total number of speculative-grade issues) reflects market sentiment in much the same way as the overall spread level, but it focuses on the issuers perceived as facing extraordinary stress, even in relatively benign periods such as this. In fact, the distressed market has proved to be an especially good predictor of defaults during periods of more favorable lending conditions. As a leading indicator of the default rate, the distress ratio shows a relationship that is broadly similar to that shown by the overall speculative-grade spread, but with a nine-month lead time as opposed to one year. The current distress ratio, at 8.5% in October, corresponds to a roughly 2.64% default rate for July 2020. This is well below our current forecast default rate of 3.9% for September, only two months later.

How We Determine Our U.S. Default Rate Forecast

Our U.S. default rate forecast is based on current observations and on expectations of the likely path of the U.S. economy and financial markets.  In addition to our baseline projection, we forecast the default rate in optimistic and pessimistic scenarios. We expect the default rate to finish at 2.5% in September 2020 (47 defaults in the trailing 12 months) in our optimistic scenario and 5.2% (97 defaults in the trailing 12 months) in our pessimistic scenario.

We determine our forecast based on a variety of factors, including our proprietary default model for the U.S. speculative-grade corporate bond market.  The main components of the model are economic variables (the unemployment rate, for example), financial variables (such as corporate profits), the Fed's Senior Loan Officer Opinion Survey on Bank Lending Practices, the interest burden, the slope of the yield curve, and credit-related variables (such as negative bias, defined as the proportion of issuers with negative outlooks or ratings on CreditWatch with negative implications).

In addition to our quantitative frameworks, we consider current market conditions and expectations.  Areas of focus can include equity and bond pricing trends and expectations, overall financing conditions, the current ratings mix, refunding needs, and both negative and positive developments within industrial sectors. We update our outlook for the U.S. speculative-grade corporate default rate each quarter after analyzing the latest economic data and expectations.

Related Research

• Weakest Links Reach A 10-Year High, Oct. 17, 2019
• The Distress Ratio Ebbs After Oil And Gas Defaults, Oct. 10, 2019
• A Double-Digit U.S. Default Rate Could Be On The Horizon, Oct. 2, 2019
• Will Trade Be The Fumble That Ends The U.S.’s Record Run? Sept. 27, 2019
• The Expansion Of The ‘B-‘ Segment Is Feeding Growing Vulnerabilities, Sept. 25, 2019
• U.S. Refinancing--$5.2 Trillion Of Rated Corporate Debt Is Scheduled To Mature Through 2024, Aug. 15, 2019
• 2018 Annual U.S. Corporate Default And Rating Transition Study, May 7, 2019
• 2018 Annual Global Corporate Default And Rating Transition Study, April 9, 2019

Research contributor: Abhik Debnath, CRISIL Global Analytical Center, an S&P affiliate, Mumbai